Dr. John Rutledge
Chief Investment Strategist at Safanad
There is a major financial storm system in Hong Kong and Shanghai. Beginning today, foreign investors and China mainland investors will be able to own each other’s stocks for the first time. It is a perfect illustration of the Safanad investment approach. Two separate systems—Hong Kong and Shanghai stock markets—with different prices and returns will be combined into one open system when the markets open to cross-border investment today. The result will be unsustainable return differentials that will lead to major price movements in both markets.
Today’s opening of two-way stock market traffic is a huge event for China, far more important than anything that took place at last week’s APEC meeting. This opening of two-way capital flows will create important opportunities for careful investors on both sides of the ball. The 3 key points to make are as follows:
- What is Shanghai Hong Kong Connect?
- What does it mean for investors?
- What does it mean for China and the world?
What is Shanghai Hong Kong Connect?
A “pilot program” that allows Chinese and foreign investors to invest in each other’s shares for the first time.
Northbound investment. Hong Kong and foreign investors will be allowed to invest in 268 designated stocks (Gang gutong shares) out of the 971 A-shares listed on the Shanghai stock exchange (SSE).
Southbound Investment. Chinese mainland investors meeting minimum balance rules will be able to invest in selected stocks listed on the Hong Kong Stock Exchange (HKSE) including stocks in the LargeCap and MidCap indexes as well as shares with dual listings in both markets.
Both lists are expected to be increased over time after the pilot program stage. Investments in both directions are subject to quota limits of 13 billion RMB, about $2 billion per day.
The Chinese government also announced it will waive capital gains taxes earned by foreign investors in the Shanghai market, at least for the initial period.
What does it mean for investors?
For Hong Kong and foreign investors this is the first opportunity to invest directly in the stocks of most of the major mainland Chinese companies, rather than being limited to ADRs and the relatively few companies listed outside China.
For mainland Chinese investors, this is the first opportunity to invest in most of the companies listed in Hong Kong. It is also their first ‘legal’ opportunity to move the wealth they have accumulated in China to other, politically safer, jurisdictions. (This is very important, given Chinese history).
The program will likely be opened to “foreign RMB investors”, i.e., foreign investors with RMB balances who want to invest directly in China, after the pilot program. The reason this is important for investors is that there have been very large price differences for the same stocks listed in both the SSE and HKSE. See table below.
This table, included in the investor briefing materials published by the SSE, shows that for the top 10 stocks listed in both markets, Hong Kong prices averaged 12.9% higher than Shanghai prices during the first 6 months of 2014 for shares in the same companies. For all 69 shares listed in both markets, however, Hong Kong shares sold at a 10.05% discount below their Shanghai levels, implying that smaller Chinese companies trade at substantially lower prices in Hong Kong than they do in Shanghai.
What do these prices mean? Foreign institutional investors, unable to buy Chinese stocks directly, drove the prices of dual-listed, large-cap Chinese companies up relative to mid-cap companies in the Hong Kong market compared with their SSE prices. When trading opens, we would expect prices to be driven closer together in both markets.
The biggest gains? Mid-caps in the Hong Kong market and large-caps in the Shanghai market. To some degree, investors have been doing this already. Shanghai prices increased +1.38% the day the program was announced last April, and +17.8% since then. Hong Kong prices +5.5% since April.
Be careful, though. The behavioral finance literature has concluded that stocks listed in 2 markets can have quite different prices for long periods, even between New York and London.
What does it mean for China and the world?
This is very important for the Chinese government. Selected language from government announcements include:
- “new era”
- “historic moment for China’s capital market”
- “breakthrough for China’s capital market”
- “facilitate the opening up of China”
- “the first train for A shares to go global”
- “a road to the overseas stock market in a short time”
- “closely related to China’s economic development”
- “market-oriented reform for interest rate and exchange rate”
- “gradual convertibility of RMB”
- “serving RMB internationalization”
- “boost Shanghai’s international financial center.”
This serves China’s plan to build a global market for the RMB. Chinese leaders concluded in 2008 that the US and EU were both unstable anchors for their monetary system. As a result, they are attempting to build their own Asia-centric currency bloc. Chinese leaders believe that opening the market will bring more capital into China, which means more stable growth.
Hong Kong’s pivotal role in developing Shanghai and the Chinese financial system is at one of the major reasons Chinese authorities are unwilling to make compromises in dealing with Hong Kong demonstrators. It is no accident that the first pilot program is being launched in Shanghai. Xi Jinping and Li Keqiang are part of the Zhang Zemin-led political faction known as the Shanghai Gang.
Wild card? This is the first time we have been able to get a good measure on the desire of mainland Chinese investors to move their wealth out of China, which will be the key to movements in the RMB/$ exchange rate. So far, it appears that investors expect foreign investor interest in China to exceed Chinese interest in going abroad. It will be interesting to see how this unfolds.